Current Account Balance, (CAB) is one of the major macroeconomic indicator that helps to evaluate country‘s external vulnerability. The importance of the CAB as the main indicator of the external sector revolves around its meaning. The CAB represents transactions between Georgian residents and residents of the rest of the world; It includes balance of goods, services, primary and secondary incomes.
The CAB and its components provide the information about the country’s external position. In particular: If the CAB is positive, country is a net borrower and if it is negative, country is a net lender as its net foreign assets decrease.
Based on the specific factors and macroeconomic environment, sometimes current account deficit (CAD) is country’s optimal policy response to achieve the stable macroeconomic development. However, permanent/long-term CAD may become source of the country’s long-term vulnerability. In this case, the economy is highly dependent on the external conjuncture, which may causes the macroeconomic volatility.
Therefore, it is vital to study the relationship of the above-mentioned external indicator with other macroeconomic variables. To this extent analyzing the relationship between the budget and current account deficits is far-reaching, as it is induced by the composition of the indicators themselves. Specifically, as the CAB includes both private and public sectors, the fiscal policy decisions can have significant influence on its dynamics. Usually, the economies that run both the fiscal and current account deficits are referred to as experiencing the “twine deficits”. And as the direction and the strength of this link may strongly vary by country, analyzing the phenomenon of the “twine deficit” for Georgia can be beneficial while analyzing the response of the fiscal policy to the different external shocks.
There are two broadly used approaches explaining the relationship between fiscal policy and the current account: theories of Mundell-Fleming and Ricardian equivalence. According to Mundell-Fleming, the budget deficits can cause the current account deficits. On the other hand, the Ricardian approach states that this relationship is not that straightforward and it depends on the various circumstances. The majority of the empirical studies show that the strength of this link may differs because of the different transmission mechanism, the country specificities and the nature of the fiscal shocks.
According to PBO’s quantitative analysis, for Georgia as for many another international studies when the budget deficit increases by 1 percentage point of GDP the current account deficit increases by 0.78 pp of GDP and vice versa; improving the budget balance reflects in the current account improvement. Also, in order to estimate the robustness of the model, 4 different modifications of the baseline model were developed and the analysis show that this impact varies between 0.75-86 pp and that the baseline results are trustworthy.
For more details see the complete document (available in Georgian)